Client Margin Protections Should Be Recognized

As a former commissioner of the Commodity Futures Trading Commission (CFTC), I can attest to the importance that has been placed by regulators on the protection of client cash collateral. At the CFTC, we worked to strengthen that protection, and issued strict rules to ensure the integrity of customer accounts and restrict their access by futures commission merchants (FCMs), except when needed to further the customer’s own activities or to resolve a customer default.

These rules ensure client collateral is segregated and accounted separately from the FCM’s other assets, and cannot be used to fund the FCM’s own operations. There are also restrictions in place to ensure the margin can only be held in cash or highly conservative and liquid instruments, such as US Treasury bonds.

Many other jurisdictions have comparable requirements in place. For instance, the UK Financial Conduct Authority’s Client Asset Sourcebook sets out requirements relating to holding client assets and client money, and provides similar protection.

As pointed out in a letter published in the Financial Times today and signed by a group of exchanges, clearing houses and industry associations including ISDA, the Basel Committee on Banking Supervision’s leverage ratio doesn’t take these client margin protections into account when determining the exposures that banks face as a result of their client clearing businesses.

This treatment has been defendedas well as criticised – by some in the regulatory community. However, this is a major flaw in the application of the leverage ratio. In its rules, the Basel Committee stresses the importance of introducing a simple measure that captures the on- and off-balance-sheet sources of leverage faced by a bank. But properly segregated client cash collateral is not a source of leverage and risk exposure. In fact, it does the opposite: it acts to reduce the exposure related to a bank’s clearing business by covering any losses that may be left by a defaulting client. This exposure-reducing effect is not recognized by the leverage ratio.

Big strides have been taken in increasing the share of derivatives cleared through central counterparties in recent years, meeting one of the key objectives set by the Group of 20 (G-20) nations in 2009. Today, roughly 75% of the interest rate derivatives market is cleared, according to US swap repository data compiled by ISDA. But the leverage ratio in its current form could threaten continued progress.

Failure to recognize the exposure-reducing effect of client cash collateral would substantially increase a clearing firm’s total leverage exposure, leading to a rise in the amount of capital required to support client clearing activities. Many firms may decide the economics simply don’t stack up – and several banks have already taken that decision and retreated from client clearing. The end result will be a reduction in capacity to clear for clients, increased concentration in a smaller number of FCMs or clearing members, and higher costs for those end users that are able to find clearing members to clear on their behalf.

That seems very much counter to the G-20 objective to incentivize greater levels of derivatives clearing. We believe further data analysis on this topic is necessary to fully understand the impact. We would therefore encourage the Basel Committee to re-open its leverage ratio rules and reconsider this issue.